If you have established a habit of saving and have built up a decent amount of cash, you may start to wonder if there is a way to hold your savings somewhere that won’t leave you exposed to inflation. There…
It’s important to understand that inflation protection is removed when taxes are applied. Current tax rules disregard inflation, and as a result it’s easy to demonstrate that inflation can cause all of our interest on a TIPS and some of…
If you looking to buy an I Bond, but you’re not sure where you need to go or what you need to do, you’ve come to the right place. Just follow these simple step-by-step instructions. They will help you set…
Bonds are one of the easiest and most common ways to save money for the long term. There’s a good chance you already own one. If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond. CD’s are quite a bit different than other kinds of bonds, but they have many things in common.
Rather than going over different kinds of bonds, I’d like to explain why they are a good investment for those of us saving for future needs. In a previous article, I described two ways of looking at our investments. Bonds are very useful for the part of our savings that we intend to preserve.
Bonds Eliminate Timing Risk
I mentioned back in my introduction to TIPS that bonds are actually a type of loan. CD’s are loans that you make to the bank. If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how. If you have had a CD before, you know that it has an end date. That’s how bonds work. They “mature.” When they do, you get your money back.
Because bonds have a due date, they are great for eliminating timing risk. Bonds come with a promise to return your money on a specific day. If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account. When the CD matures, you get your money back and all the interest right when you need it.
You can imagine what might happen if you put that money in a mutual fund for two years. If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans. It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.
Certificates of Deposit and Inflation
Taking out a two year CD might not be that bad. At the time I write this, CD rates are still quite a bit lower than the rate of inflation. When that is true, you end up paying the bank to hold and protect your money. That’s not always a bad idea. Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?
I Bonds vs. CD’s
You might consider I Bonds for a two year holding time or more. You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea. If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest. It’s still better than most bank CDs at the time that I write this. After five years of waiting, you can take the money out any time. If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one. You can find out more about I Bonds in another article.
The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation. There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point. The problem with that is that interest rates and inflation are not really linked. The will of the government is in between. Governments occasionally force interest rates lower as a way to “fix” the economy. As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.
Using a Bond Ladder
You may have seen an article or heard someone at your bank talk about putting some money in a CD ladder. This arrangement helps you take advantage of changes in interest rates over time. It’s another way to attempt to deal with inflation issues as well.
The idea is that you split up your money, and buy CD’s or bonds with different maturity dates. For instance you might buy one for six months, another for one year and another for two years. The idea being that every six months you would have a CD coming due. When it does, it allows you choose whether you need to use some of the money or put it back into another CD. It also allows you to take advantage of changes in the interest rates as they go up.
When you are trying to save your money for later, bond ladders have much different purpose. When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates. Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing. When we are dealing with the preservation side, what we concern ourselves with is timing. We just need to ask ourselves: When do I need this money? In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.
Here’s an example. Suppose you need your money in 15 years. It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures. You can think of your needs like buckets of money. Let’s say that you have one bucket for each year during your retirement. You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.
Beware of Bond Mutual Funds
Bond mutual funds don’t have a maturity date. Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds. That’s because the fund share prices change every day based on market forces, not inflation. I plan to explain that more in an article about mutual funds.
A Smart Way to Plan
Bonds are a great way to plan because they are based on time commitments. Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.
Copyright © Troy Taft 2020
Here’s a list of 10 articles I found that provide information about Inflation Protected Bonds. Learn more about how I Bonds and TIPS work and good reasons to use them for long-term savings.
This is an interview with Professor Zvi Bodie about the safest way to invest for your retirement needs. He explains the clear benefits and why he believes that more people need to hear about this ultra-safe way to prepare for retirement.
This overview of I Bonds briefly explains their benefits and how they compare to other investments in general. It describes I Bonds as a safer investment than other kinds of investments. It has some very helpful graphics. I believe is the best site about I Bonds I have found. You might want to spend some time here looking around at all it has to offer. This site also sports an up-to-date display of the current interest rate being offered by I Bonds in the upper right hand corner and contains great quotes that people have made about the benefits of I Bonds.
by Fidelity Viewpoints, Fidelity Investments
This article provides a good overview of TIPS from an investment perspective. It also has a discussion about ETFs that give smaller investors access to something called Floating Rate Loans. I’m not a fan of those at this time, but this article does have a discussion of those as well.
by Christina Granville, Investopedia
This article give some great background on the history of Inflation Linked Bonds and provides a brief overview of how they relate to investments in an investment strategy. I tend to not care about investment strategies in that I use inflation protected bonds for long-term savings. This article also provides the names the inflation protected bonds available in other countries. Don’t get too concerned about the discussion about deflation. She mentions at the end, it doesn’t apply to those of us using it for long-term savings. I intend to address that issue in another article.
by Wade Pfau on Forbes
This article is directed toward those of you who already think in investing terms. It’s a bit technical compared to some of the other articles. The author discusses some of the oddities regarding TIPS and their relationship to other bond investments. He briefly discusses the idea of real and nominal yield and the difference in thinking that goes along with investing in TIPS.
by Dan Caplinger on The Motley Fool
This is a great article that covers the history that the United States had with the bond market and inflation during the 1970s and 80s. It does a great job of explaining the benefit and protection that TIPS provide. The article concludes by recommending ETFs and Mutual Funds. I’m not a huge fan of funds. I hope to explain my viewpoint in a future article, but I have held them at times because I believe that they are some of the safest ones to hold. This article is not very technical and a great one to read to get some background on TIPS.
by Thomas Kenny at The Balance
One of the most alarming and confusing things to discover about investing in TIPS is that they can show a negative yield during certain times in the economy. This article explains why that happens. This is another topic I hope to make more clear in the future as well. It’s good to note that your bank account has been giving you negative yields for several years in a row when you adjust your returns for inflation. TIPS are just more easily exposed when this happens. You can choose to not buy TIPS when they go negative.
by TIPS Watch
This is a page on a site all about TIPS that tracks the interest rates of I Bonds. It also explains how I Bond rates are calculated. If you want to see the history of I Bond rates, you can see that on this tracking page.
This is the United States Treasury Department’s information on I Bonds. You can get all of the most accurate and latest information here including the current interest rates and how they are calculated. If you want to buy them, you are only a few clicks away.
Here is the United States Treasury Departments description of TIPS. This is where you will find the most up-to-date information on them. It’s not that hard to understand but you may need to invest a little time reading and thinking about it. I don’t think you need to know much about investing to understand what it said here. You can also buy TIPS directly from this site.
Copyright © Troy Taft 2020
So, you are at the point where you have decided to stay out of the market and all you really want to do is save what you have for later. The problem is, you haven’t found a way to save money for longer than a year or so, without feeling the effects of inflation. A simple look at the inflation rates reveal that you would have to get an interest rate of somewhere around 2% just to break even! With 5 year CD rates at 1.5%, you realize that you would be paying the bank half a percent to keep your money from you! If you were an irresponsible spender, that might make sense, but you are serious about saving. Now, am I the only one who thinks this is crazy? Why are more people not upset about this?
Running Toward Risk
One reason might be that people have been placated by the possibility that they could make money using the stock market. It’s hard for me to believe that this was not the intent of denying us the right to save our money. I believe it is dishonest for any government to act like money is money if it can’t be saved for more than a few months. It would also be pretty hypocritical for a government to complain about the number of people without savings, if they haven’t even provided a way to save this so-called money. Well, I’m happy to inform you that they actually have provided a way to save. There must be a few godly people in the government because they gave us a way to save money that can actually avoid much of the exposure to inflation. In the United States, there are actually two ways. They aren’t perfect, but they do appear to be a step in a good direction. This information is so little known, and so important, that I really wanted to share it.
The Old Way
I’m going to assume that you are familiar with how a savings account accrues interest. It’s important that you also understand how CDs or Certificates of Deposit work at the bank too. A typical CD is a special account in which you give the bank your money for a dedicated amount of time with the promise from them to pay you interest. If you take your money out early, there is a penalty. The interest is calculated on the amount of money you initially put into the account, plus any interest accrued. Now if that interest rate is less than the rate of inflation, you are actually losing money. That’s because what you can actually buy with the money has become less over time, while at the same time, the interest didn’t increase fast enough to give you the same purchasing power your money had when you earned it. So what did the United States Government do to help us in this situation?
The New Way
In 1997 the United States Treasury provided a new way of saving by issuing something called: “I Bonds. ” In order to understand what those are, you kind of need to understand what a normal “bond” is. Stocks and bonds are really different even though they are often spoken of together. When you “buy” a bond, you are actually loaning your money to someone. Pretty confusing right? It sounds like you are purchasing something when, in reality, you are loaning someone else your money! Well, no matter what it seems like, that’s what it is. When you buy a bond, you become the bank. You can loan money to companies by buying corporate bonds. You can also loan money to a government by buying government bonds. That’s one way that United States Treasury finances their needs and they allow individuals or institutions to buy bonds. One institution that does this is, … surprise…. your bank. In fact, those CDs you get are often backed by government bonds. I tell you this to help you understand that that these I Bonds are not really a new risk to you. You are accessing the same United States Treasury only in a different way. Let’s look at how a typical bond earns money for you.
A good old-fashioned bond used to be printed on paper, kind of like a dollar bill. On the face of this bill, it had a value, like $100. If you were to buy this bond at its face value you would loan the government $100 and they would give you this bill. In those days, part of your loan agreement was that every six months or so, the government would pay you by sending you a coupon in the mail for all the interest they owed you on that money so far. You could then go cash the coupon and use the money. That was your interest for allowing the government to use your $100. Another thing about your bill is that it would have a term associated with it that was recorded in a book somewhere. That’s the amount of time you agreed to allow the government to use your $100. When time is up, you can cash in your bill to get your $100 back. As long as they are using your $100, they promise to keep sending you your interest as coupons in the mail. Well, it’s pretty obvious that computers were bound to change this process a bit.
Buying Treasury Bonds Today
Now days, we use the same terms, but the paper is almost gone. You still can buy a bond, but the coupon never gets sent to you, it just accumulates in an account. In fact, the Treasury is willing to compound the interest now just like a CD. Not only that, you can go to the Treasury’s web site and open an account online, just like using online banking. Anyone with a Social Security Number is eligible. Their website even has a clever name:
Yes, you have your very own online bank account waiting for you, but wait, there’s more. Let’s go back to talking about I Bonds. I Bonds, or more accurately Series I Savings Bonds, are what the Treasury calls “Inflation Adjusted Bonds”. That’s right. They’re bonds whose interest is tied to inflation. That means that when inflation goes up, the interest rate on these bonds go up too. Part of the interest calculation is connected to an index that follows the cost of goods in the United States called the CPI-U. The CPI-U is a good topic for another article. It’s good to know, for now, that your interest rate will go up when inflation goes up. It’s also important to understand that what goes up, must also come down. If inflation goes down (yes that would be deflation) the rate goes down, but the Treasury decided that they would not allow your bonds to ever go below your original amount. That means you could actually make money in a deflationary time as well. If you want to buy an I Bond, I have step-by-step instructions available at this website.
The Tax Problem
Now let’s say that you are convinced and you’re ready to put some of your savings into one of these I Bonds. First, let’s talk about the down side. I Bonds, unfortunately, are not protected from taxation by the IRS. The United States Tax Code, for some reason, doesn’t recognize the fact that you already earned this money once. Evidently, our congress believed that simply recovering your money’s lost value to inflation is a taxable event and that we owe money for that. This means that you aren’t completely protected from inflation. You will have to treat your interest on an I Bond as “income” and report it. That’s the bad news. This same bad news spans all investments including your bank account. That’s not much comfort, but there are two tax advantages that you also need to consider as well.
First, we are allowed to defer reporting our interest to the IRS. You can choose to not report your interest until you need to use the money. The reason that this is significant is that you can wait to use the money for a rainy day, such as, a year when you don’t have much income. For many of us, that will probably be during retirement. At that time, you may not even be taxed, depending on what other income you have. The other advantage is that these bonds are not taxable by state or local governments, like your bank account is. So, even though taxes make things less than perfect when trying to shelter yourself from inflation, these I Bonds are one of the best things we have.
If you are interested in learning more about the effects of taxes on our inflation-protected savings, make sure to check out my post: Inflation Protection and Taxes.
Some Important Details
Now for some important details about I Bonds: You can buy an I Bond for $25 or more at Treasury Direct, but you can’t buy more than $10,000 in any given year. For many of us, that’s not an issue, but there are some who would like to save more than that. Well, there is another trick… You can use your tax return to buy about $5000 more and guess what, you will get the paper certificates! They are pretty cool, I have to admit. There are more pictures of them at Treasury Direct.
Also, I Bonds are a long-term investment. They act kind of like a CD in that there are restrictions about when you can take the money out. You can’t cash them in for the first full year. Also, you are penalized if you cash out before a 5 year term, but the penalty is not very bad. You would have to give up the previous three months of interest, but that’s it. Since you probably want to save anyway so that’s not a big deal. The good thing is that you can keep your money in this bond for 30 years! Yes you read that right. Anywhere from 5 to 30 years, the government is willing to keep growing your interest rate with inflation and allow you cash out any time. After 30 years the interest stops so it’s a good idea to cash it in and get a new one so you keep earning interest.
If you are looking to shelter more than that, or were wondering how you could do something like this in a retirement account, there is another option. Check out my post: Introducing Treasury Inflation Protected Securities (TIPS). Thankfully, you can save money after all!
Copyright © Troy Taft 2020